The big conundrum called Angel Tax

Angel and seed funding deals halved to 435 in 2017 from 901 in 2016, says a report, while the total disclosed value of these deals fell to $245 million from $374 million. Angel tax is one of the big issues plaguing the sector, and startup founders were expecting the union budget to address the issue. But it wasn't.

Angel Tax refers to Section 56 (2) (viib) of the Indian Income Tax Act, 1961, wherein the Income Tax Authorities are demanding additional taxes from startups who have received funding from Indian resident ‘Angel Investors’ at a valuation higher than what can be perceived for an early stage start-up venture.

Challenges faced by government

Black money hoarders, in conjunction with finance professionals and government officials, developed a practice wherein closely-held companies could bring in undisclosed money of promoters/directors or even third parties (for a commission) by issuing shares at a high premium, which is normally over and above the book value.

Moreover, in case of many closely-held companies, promoters would issue shares at a premium with the purpose of keeping share capital low, yet the capital base stronger, so that breakup value and market value is high. This leads to the advantage of low cost of servicing share capital, and also improved prospects to issue shares at a premium in future by way of initial issue of offering by promoters.

Problems faced by Startups and Angel Investors

The main controversy is in the concept of 'fair value'. Investors value a company based on its potential and future capacity, vouching on its founders and team, overall idea, scale, footprint, GMV, growth rate, revenue and run rate. However, the problem arises when the performance of the company doesn't match its initial projections and the Income Tax Department, due to the benefit of hindsight, invalidates the original valuation, thereby, reducing its 'fair value' at the time of assessment and increasing the premium amount on which the tax is to be levied.

Startups work on certain presumptions, and each valuation is done after rounds of negotiations, valuation reports, bankers' reports, and several other regulatory compliance between a company's promoters and the investors. In fact, there can be circumstances that the company is struggling to stay afloat and its valuation would have decreased anyways.

But that doesn't invalidate original projections. There are several reports that suggest that almost 80 percent of startups fail within the first five years. Several founders and investors have been questioning the rationale of the IT department asking startups to pay tax on the amount they raised two to three years back, irrespective of whether they made profits or not.

The underlying issue seems to be the problem in the revenue recognition policy of the Income Tax Department. The IT officials have targets to meet for the revenue collection, just like sales people in companies. To top that, if they book the company by sending a demand notice, the specified amount becomes a part of their revenue, and is an easy way to meet targets.